Ignore the market’s 2013 results and diversify

Investors are showing selective reasoning and wishful thinking

1. They are feeling like now is the perfect time to throw all of their chips back into the market.

2. They believe that diversification no longer works.

You can come to both conclusions by looking back at 2013 and ignoring everything but the most positive conclusions to be drawn from the stock market.

These attitudes typically go hand in hand, as they did after 1999 when investors eschewed diversification and caution and threw everything into the investment categories that were about to be gutted by the bursting of the Internet bubble. They did it again—though in the opposite direction—after 2008, yanking their money out of a market that cratered after the financial crisis, feeling that diversification had failed to protect them.

Both feelings show a dangerous “recency bias,” the temptation to believe that what has happened most recently will be what is going to happen next.

They also show selective reasoning and wishful thinking.

In the investment world, it’s pretty easy to find an exception to any narrative. For example, a growth investor will show die-hard value investors periods where their preferred style failed, and vice versa.

That’s foolhardy thinking, looking for a pattern where typically none exists or going off-track to make the point.

There’s no denying that the Standard & Poor’s 500 was up just about 30 percent last year, and that with dividends tossed in, total return was north of 31%, surpassing virtually every other asset class.

Thus, diversification didn’t work, if the object of investing in assets outside of domestic stocks was to increase returns.

Now you could quarrel with the “diversification failed” argument by noting that several foreign indexes did better than the domestics during the last half of the year, or by noting that Japanese stocks, as represented by the Nikkei index, were up more than 50%, but that continues the argument rather than ending it.

Diversification wasn’t meant to maximize short-term returns or to pick the asset class that will perform best in any given time period.

It doesn’t guarantee positive returns—a point used against it after 2008—but it’s not supposed to.

A year ago, anyone speculating on the best asset class to invest in would not have been guessing a 30-plus percent gain in domestic stocks, with nothing else keeping pace.

Putting money into a lot of different asset classes, therefore, would have been a protective move, a chance to benefit no matter what did well. You lose the bragging rights that come with picking the best asset class and betting on it with your entire portfolio, but you don’t suffer as much from being wrong.

In short, think of it like putting a sound, solid roof over your financial home. You can’t argue that roof has no value—compared with someone else living with leaky thinking—just because the sun is shining; the sun won’t shine forever.

Judy Shine of Shine Investment Advisory in Lone Tree, Colo., noted that she would assume that people arguing against diversification right now are the ones throwing their money into the market in a concentrated fashion, going after what looks best now, a strategy she described as “market-timing, better known as guesswork.”

“What is the winning asset allocation for 2014? No one knew the direction for 2013 and no one knows the direction for 2014,” Shine says. Diversification always works. It means you never suffer the big hit, so you never bail. It has nothing to do with being 100% invested in the highest-returning asset class and everything to do with the fact that investors cannot push beyond their point of pain in equities. Smaller successes mean you will stay in place.”

Frank Armstrong of Investor Solutions in Miami made it clear to clients in his year-end report that several asset classes led to lagging the equity targets for portfolios, “but even the best strategy will underperform its benchmark at some points. We believe that our strategy will outperform the global index by a significant amount without significantly increased risk over the long haul. But, we certainly don’t believe it will happen in every time period. Not to be too cavalier, but, to quote a fine old American saying, ‘Some days you get the bear, and sometimes the bear gets you.’”

Ultimately, it highlights the choices investors face now, a difference between doing what’s comfortable and feels good, and doing what’s most likely best for their long-term financial health.

The easy choice is to pile into the market with what has worked lately, and to let their winners run, hoping that they don’t get burned even as virtually every financial expert is warning that 2014 will not be a repeat of the year just completed.

That’s sticking with their leaky roof and hoping the sun keeps shining.

Or they can plow money into assets that spread their money around, rebalancing portfolios to put them back onto target allocations, even if it means not buying into the asset class that led the world in 2013.

Says Dan Dorval of Dorval & Chorne Financial Advisors in Otsego, Minn.: “Diversification offers reward at the times of greatest risk, which generally involve a major trend reversal. We never know for sure when these trend reversals will occur so we sacrifice some return during periods of speculative excess in exchange for reward when that speculation is punished. In our opinion, this is a terrible time to lose diversification discipline.”

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